A valuable walk through a 10-K

Partnoy and Eisinger keep it simple

Sometimes, when faced with the unholy mess that is financial regulation, the best idea is to keep it simple, and that’s what Frank Partnoy and Jesse Eisinger do in this fabulous story on financial disclosure, or, more accurately, non-disclosure.

They simply sit down and try to read, in good faith, the annual report of a mega-bank, in this case, Wells Fargo. This document, also known as form 10-K , is filed with the Securities and Exchange Commission and available online for anyone to see. (Weirdly, I can’t find it on the SEC’s Edgar site; if anyone can let me know, and I’ll change the link. Update: Thanks to Matt below, here it is.)

The trouble is its hundreds of pages of fine print obscure more than they reveal, and do so by design. This is important for about trillion reasons, but one of the main ones, as the piece makes clear, is that the system rests on the ability of the market—that is, the wisdom of a crowd of trained and incentivized professionals —to scrub such things and assess the risks. But if the disclosure contains gaping holes, the system’s entire rationale falls apart, and the broader society must ultimately absorb whatever negative externalities will result. This we learned at great cost during the financial crisis.

What I love about this story (and not everyone did) is that it’s written for a mass audience about a subject that, while highly technical, is one of those that, like global warming or nuclear safety, potentially involves everyone. And like those subjects, it is also eminently understandable when properly explained. This is true even of rocket science, by the way. Journalism like this gives the curious non-specialist—that is to say, most of us— a chance to take part in a discussion that should absolutely not be left to the cognoscenti—another big lesson of the crisis. What’s more, even among those who read financial statements for a living, how many have slogged through a mega-bank’s 10-K to figure out what it exactly does and doesn’t say? Most people, I suspect, look them over, then drop it after realizing they’re not learning much. But that’s the point.

The story is about 9,500 words. A commenter on Felix Salmon’s blog (also linked above) called it “indulgent,” but it’s really not and reads well.

I’ll pull a couple of items out that illustrate how little is revealed by even the most diligent reading. Here’s a discussion of a disclosure about something called “customer accommodation,” making trades on behalf of customers, that includes a nice explanation of the idea of notional value:

That might seem safe, but the report notably fails to explain why this activity would be so profitable. In fact, at many large banks, customer accommodation can be a euphemism for “massive derivatives bets.” For Wells Fargo, the subcategory of “customer accommodation, trading and other free-standing derivatives” included derivatives trades of about $2.8 trillion in “notional amount” as of the end of 2011, meaning that the underlying positions referenced in the bank’s derivatives were that large then. By way of explanation: if we were to make a bet with you about how much the price of a $70 share of Walmart would change this year—we pay you any increase, you pay us any decrease—we’d say the “notional amount” of the bet is $70.

Wells Fargo doesn’t expect to gain or lose $2.8 trillion on its derivatives, any more than we would expect the payment on our Walmart bet to be $70. Bankers generally assume that the likely risk of gain or loss on derivatives is much smaller than their “notional amount,” and Wells Fargo says the concept “is not, when viewed in isolation, a meaningful measure of the risk profile of the instruments.” Moreover, Wells Fargo reports that many of its derivatives offset each other, as yours might if you placed several wagers that Walmart stock would go up, along with several other bets that it would go down.

Yet, as investors in bank stocks learned in 2008, it is possible to lose a large portion of the “notional amount” of a derivatives trade if a bet goes terribly wrong.

In the future, if interest rates skyrocket or the euro unravels, Wells Fargo might sustain huge derivatives losses, just as you might lose the full $70 you bet on Walmart if the company went bust. Wells Fargo doesn’t tell investors how much of the $2.8 trillion it could lose in a worst-case scenario, nor is it required to. Even a savvy investor who reads the footnotes can only guess at what the bank’s potential risk exposure to derivatives might be.

For me, the most valuable bit was looking at how assets, including exotic securities, are valued. I’ve spent a bit of time looking over Citigroup’s 2005 10-K for a book I’m writing, wondering how much of the pending catastrophe was visible to the curious reporter at the time. There were clues, and certainly it provided the basis for many questions. But in and of itself, it is a deeply deceptive document.

It turns out, disclosure hasn’t improved much. Really, the holes are shocking, given the crisis. The authors explain that banks classify assets based on a three-level hierarchy. Level 1 is publicly traded stuff. Level 2 includes mortgage-backed securities and derivatives, which themselves are not simple to value. And then there’s Level 3:

Level 3 is hair-raising. The bank’s Level 3 estimates are “generated primarily from model-based techniques that use significant assumptions not observable in the market.” In other words, not only are there no data about the prices at which these types of assets have recently traded, but there are no observable data to inform the assumptions one might use to generate prices. Level 3 contains the most-esoteric financial instruments—including the credit-default swaps and synthetic collateralized debt obligations that became so popular and prevalent at the height of the housing boom, filling the balance sheets of Bear Stearns, Merrill Lynch, Citigroup, and many other banks.

At Level 3, fair value is a guess based on statistical models, but with inputs that are “not observable.” Instead of basing estimates on market data, banks use their own assumptions and internal information. At Level 3, fair value is an uneducated guess.

Surely, one would assume, Wells Fargo’s assets would mostly reside on Level 1, with perhaps a small amount on Level 2. It’s just a simple mortgage bank, right? And it seems inconceivable that Wells Fargo would be loaded with Level 3 investments long after regulators have supposedly purged the banks of toxic assets and nursed them back to health.

Yet only a small fraction of Wells Fargo’s assets are on Level 1. Most of what the bank holds is on Level 2. And a whopping $53 billion—equivalent to more than a third of the bank’s capital reserves—is on Level 3. All three categories include risky assets that might lose value in the future. But the additional concern with Level 2 and Level 3 assets is that banks might have errantly recorded them at values that were inflated to begin with. There is no way to check whether reported values are accurate; investors have to trust the bank’s managers and auditors. Scholarly research on Level 3 assets suggests that they can be misstated by as much as 15 percent at any given time, even if the market is stable. If Wells Fargo’s estimates are that far off, the bank could be sitting on billions of dollars of hidden losses.

One thing I like about this piece is that it shows, five-years after the crisis, we still really haven’t moved on. The opacity of banks’ assets was precisely the problem in the run-up to the Lehman crash. Even the short sellers were guessing. They just happened to be right.

Banking is complicated. And there’s nothing wrong with that, I suppose, in principle. So, yes, regulation must be sophisticated. We know that. But Partnoy and Eisinger have it just right that the bedrock principles underlying them are not complicated at all.

The starting point for any solution to the recurring problems with banks is to rebuild the twin pillars of regulation that Congress built in 1933 and 1934, in the aftermath of the 1929 crash. First, there must be a straightforward standard of disclosure for Wells Fargo and its banking brethren to follow: describe risks in commonsense terms that an investor can understand. Second, there must be a real risk of punishment for bank executives who mislead investors, or otherwise perpetrate fraud and abuse.

Anyone can understand that.

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